Will West Asia conflict delay interest rate cuts by central banks? Here’s what’s happening

Investor sentiment has shifted rapidly in response to the Iran war and the resulting spike in energy prices. Market participants now anticipate that central banks may hold off on expected rate cuts, and in some cases, even consider raising interest rates before year-end, as per a report. 

According to Financial Times, the European Central Bank (ECB) is now expected to increase its key rate once or twice this year, according to swap contracts. The Bank of England (BoE) is also seen as a candidate for a possible rate hike by year-end, a significant turnaround from previously anticipated cuts. The change reflects heightened inflationary pressures as oil and gas prices surge, prompting a re-evaluation of risk and policy direction among key global central banks.

In the United States, expectations for Federal Reserve rate cuts have diminished, with markets now pricing in just one or two quarter-point moves, compared to as many as three before the conflict, it said. Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management said there is a risk of global repricing. 

This shift is informed by lessons learned after Russia’s invasion of Ukraine in 2022, when central banks were criticised for slow responses. Analysts noted that central bankers have traditionally preferred to “look through” energy price spikes, hoping higher costs would eventually restrain demand. However, the previous lag in tightening policy has left institutions cautious about repeating past mistakes. 

Despite market moves, central banks have not signalled imminent policy changes. ECB policymakers continue to highlight potential inflation risks if the Middle East conflict is protracted, especially if oil and gas supplies remain disrupted. Philip Lane, the ECB’s chief economist, recently warned that a prolonged war could trigger a “substantial spike” in inflation and a “sharp drop in output” in the Eurozone.

Some analysts regard current market pricing as excessive. Karsten Junius, economist at J Safra Sarasin, said if the conflict causes a 15 per cent rise in oil prices this year, Euro area inflation would increase by just 0.25 percentage points, remaining “entirely in line” with the ECB’s medium-term target.

The Bank of England faces a particularly complex environment. Market data indicate a roughly 30 per cent chance of a BoE rate rise from the current 3.75 per cent level by year-end, the report added. 

Inflation in the UK, at 3 per cent, remains above the BoE’s 2 per cent target. While household inflation expectations have moderated, a YouGov/Citigroup survey found expectations for consumer price growth at 3.3 per cent even before the Iran war. The BoE has faced criticism for its response to previous inflation shocks and has been reforming its forecasting and communications, with more emphasis on “scenarios” and less on single forecasts.

Other central banks are also adjusting. The Swiss National Bank, recently considered likely to cut rates, is now expected to raise them by up to half a percentage point this year. The Bank of Canada, previously seen as favouring cuts, is also now expected to increase rates by year-end.